Real business cycle theory is not dead

In this paper, we perform a structural Bayesian estimation of the
contribution of anticipated shocks to business cycles in the postwar
United States. Our theoretical framework is a real-business-cycle model
augmented with four real rigidities: investment adjustment costs,
variable capacity utilization, habit formation in consumption, and
habit formation in leisure. Business cycles are assumed to be driven by
permanent and stationary neutral productivity shocks, permanent
investment-specific shocks, and government spending shocks. Each of
these shocks is buffeted by four types of structural innovations:
unanticipated innovations and innovations anticipated one, two, and
three quarters in advance. We find that anticipated shocks account for
more than two thirds of predicted aggregate fluctuations. This result
is robust to estimating a variant of the model featuring a parametric
wealth elasticity of labor supply.

Jerry-rigged, yes. But the principle of Occam’s Razor isn’t as strong as many people think. If the mechanisms governing real world outcomes actually are that complicated, and if the simpler theories have failed, than jerry-rigging it is. And, as Christina Romer has pointed out, deflationary money shocks are still bad for output and employment, which means the theory has at least an extra branch.

I have noticed that Tyler has a soft spot for RBCT. There is something about this theory that is quite appealing to him. Why? Is it because the idea of a single explanation for both growth and cyclicality appeals to him aesthetically? (Recall his interest in quantum mechanics as well; could be the same dynamic at work.) Is it because it was the first BC model that he worked from beginning to end, and thus he harbors fond memories of it? Is it because the moral neutrality of RBCT–the idea of recession as an optimal response–appeals to him ideologically?

P.S. the real antidote to the complexity of the real world is humility. Economists should stop pretending that we can come up with useful theories of everything, for example theories of phenomena like the so-called “business cycles” that consist of actions deriving from the unique thoughts of millions of human brains. By the pigeonhole principle, these phenomena are vastly more complex than one brain could possibly comphrehend.

Instead we should honor economists for describing small things well. Not even physicists have a theory of everything, despite physics being far simpler and more objective than the study of humankind.